Question

Explain the concept of Investment Multiplier using a diagram.

Answer 1

1. Once made, an investment has the potential to generate revenue in multiples of the initial amount. An investment multiplier is thus the ratio of income growth to investment growth.
2. Assume the government of the country spends ₹100 crores on road construction, i.e. ΔI = ₹100. The first effect is that it raises the income of workers by millions of rupees.
3. Assume MPC = 0.75, which is 0.75 times 100 on consumer goods. Producers of these commodities will get an additional 75 crores. This additional money, i.e. 0.75 × 75 = 56.25 crores, will be spent on products.
4. This process will go on till the change in income becomes equal to multiple times changes in investment.

Round	AI	AY	AC
I	100	100	75
II		75	56.25
III		56.25	42.18
Total		400	300

Additional income = ₹ 400

`K = (ΔY)/(ΔI)`

`400/100 = 4`

The working of the multiplier can be shown with the help of the following diagram:

In the graph, AD ⇒ C + I is the Aggregate demand curve, intersecting with the AS curve at point E.

Due to the additional investment (ΔI), the AD curve shifts to AD₂ ⇒ C + I + AI, giving a new equilibrium level of income OY₁, showing the effect of the multiplier.